Case 2

Pre-class Assignment
Please answer these questions and upload your answers.
1. Before making his Investment decisions, Edgar considers different factors. From your study
of IBM and Interstate Bakeries cases make a list of those factors and classify them in three
categories: (i) Macro-environmental factors, (ii) Industry-specific factors and (iii) company-
specific factors.

Ans. (i) Macro-environmental factors-

 Government intervention
 Economic conditions of country
 Foreign Investment rules
 Environmental policy of government

(ii) Industry-specific factors-

 Intensity of competition
 Purchasing power of consumers
 Price volatility of inputs or degree of control over the prices of inputs
 Growth opportunities of industry

(iii) Company-specific factors- Edgar considers company specific factors are,

 Balance sheet- The balance sheet should have financial and accounting strengths
some are, debt/equity ratios, liquidity, depreciation rates, accounting practices,
pension and health care benefits and ‘hidden’ asset & liabilities.
 Company management- Competence, motivation and character of management is
important. The management stated goals and strategies and whether in the past the
management was successful in implementing the same.
 Company’s business fundamentals- The major key forces which makes the business
work some are, product & services, reputation, competition & protection from
future technology or other changes, cost structure, growth opportunities, pricing
power, dependence on economy, government regulation etc.
o After this, we can start look for estimating earnings and cash flows.
 Model building/ valuation- Projecting future revenues and cash flows of the
company is critical to value the company. Valuation is based on multiple of projected
revenues and cash flow.

2. What is Edgar’s analysis of the Bakery industry? How will you put this analysis in Porter’s
Five Forces model?

Ans. Edgar analysis of bakery industry,

 Bakery industry is not based on brand preference of any company, consumers directly
purchase whichever bread/ bakery products they see or are at low cost
 This gives seller (stores) of bakery products a bargaining power over producer as they can
directly say NO to sell any company’s product
  Drivers of the vehicles which is used for transportation have serious cost structure and is
dependent on oil prices
 The thrift shops are necessary burden on company as they are unprofitable
 The margins in the business are thin and are subject to high fluctuation in raw material cost
 There are NO MOATS in the bakery business and so it is difficult to earn a decent profit
 The workers union have given resistance to the company in improving the efficiency of
their work
 The unionized workers are participants in multiemployer pension plans that the bakeries
have little control over—and that can become unquantifiable and burdensome liabilities to
the bakery company

Porter five forces model,

 Industry Rivalry- Rivalry is High. Company had a small share in the total market and
Interstate made a lot of acquisitions to become a leading player.
 Supplier power- Neutral. Since major input were wheat and fuel, the prices of both were
dependent on the demand and supply factors- if supply was high of wheat because of
bumper production prices will fall.
 Power of Buyers- High. High, since there was high competition a retailer can shift to another
manufacturer if price is high.
 Threat of new entrants- Medium. Though its a very capital-intensive industry and does not
have stringent government rules for entry, but profit margins are very low and fluctuating.
This can discourage new entrants
 Threat of substitutes- High. Consumers can easily switch to other products.

3. “Shareholders make money off the Income statement but survives of the balance sheet”.
What is the meaning of this statement? Explain. How did Interstate Bakeries develop a fatal
balance sheet by 2004?

Ans. Statement meaning-

 Shareholders receive ‘Cash Dividends, bonus shares, or company can repurchase share
(usually higher than current stock price), issue bonus shares’
 This is many financed by profits which comes off the Income statement. The company can
perform above mentioned activities only if they earn decent amount of profits.
 After all debt obligations, accounting requirements, if company generate sufficient profits
the above amount is deducted
 While balance sheet is important for the company if it wants to grow is business further
 For this, it requires to invest in advance machinery, technology, R&D, merger and acquisition
etc.
 The above investment can only be done if the company have ‘healthy balance sheet’.
Meaning the current debt levels, cash levels should be sufficient enough to fulfill current
business requirements. It also helps to raise capital either through debt /equity as banks or
investors invest in financially sound company
 Thus, good balance sheet helps the company to expand further

Interstate bakeries Fatal balance sheet by 2004-

 Interstate bakeries was acquired by Hatch-First Boston group in 1987 at price of

$40.5/share, which was extremely high considering the market and company performance
(as the results were just elevated and were not permanent)
  In 1995, it acquired a troubled subsidiary of Ralston Purina for $330M cash plus $16.9M
newly issued interstate shares
 Five years later, it repurchased 15.5 million of the 16.9 million shares held by Ralston Purina
for $244 million.
 The repurchase increased Interstate’s debt by $244 million and reduced its tangible book
value by a same amount. In 2001, Interstate had net debt of $595 million and a tangible
book value of minus $20 million—which, of course, is a totally precarious balance sheet.
 This led to disaster three years later, when operating losses triggered a violation in the
company’s bond indentures & the company was in deep financial trouble
 Thus, in 2004 it filed for bankruptcy
 All this was mainly due to wishful thinking of management and CEO Bob hatch which
overleveraged the company and it could not get out of the debt trap

4. In 1985, analyzing Interstate Bakeries, Edgar projected the market price of its stock at $25,
66% above the current market price. Present Edgar assumptions and calculations in a tabular
form (do your calculations in excel and paste here).

Ans.

Edgar used Less P/E than market average due to low business margins and dependent on may
factors.

5. Edgar argues that 50-year average P/E ratio for the market as a whole (based on the S&P
500) is 15.8. He uses this ratio as a reference point. Explore for similar long-term average P/E
Ratio for the Indian Market. What is your most reliable estimate of this? What is the current
average P/E for the US market? Is the average P/E Ratio in India is higher or lower than the
average P/E Ratio in the US? What might be the reason for this difference? (Quote your
sources of Information).

Ans. Indian market Nifty 50 has current P/E ratio of 20.1. (as per July 2022). While that of US market
S&P 500 P/E ratio is 20.57 (as per July 2022).
  From above values we can see that US market is slightly higher in P/E compared to Indian
markets. Though the current difference is very little
 The difference is less is due to the recession fears in USA. USA currently has 41-year inflation
rate of 9.1% while in India it is 7.01%. The current Russia-Ukraine war has led the oil prices
soaring while the after effects are Covid-19 is also the other reason
 Also, supply chain issues are still dominant as China’s ‘Zero Covid policy’ is hampering this
equation
 If we compare P/E ratio of two countries a year before (July 2021), USA had P/E of 36.7 &
India P/E of 28.6. Here we can see the difference is quite substantial, as the war effects on
commodity prices & supply chain woes were less and so markets were in Bull run.

Source- WSJ Markets and Trendlyne

https://www.wsj.com/market-data/stocks/peyields

https://trendlyne.com/equity/PE/NIFTY50/1887/nifty-50-price-to-earning-ratios/

6. Why did Edgar use P/E Ratio of 11, not 15.8, for valuation of Interstate Bakeries?

Ans. Edgar used P/E ratio of 11, which was lower than average P/E of the market because of below
average quality and growth potential. Other reasons were,

 The balance sheet was OK

 Management seemed competent and motivated
 The business was low-margined and otherwise unattractive
 As a best guess, revenues might grow at a 5 percent average annual rate
 A projection by Bob Hatch that pretax margins could increase to 3.5 percent within a few
years seemed credible.

7. “If anyone thinks he has a formula for analyzing common stocks, he does not understand
how to understand how to analyze common stocks.” Do you agree with this statement? Why
does Edgar describe the valuation of a company “quite messy” process?

Ans. Yes, I agree with this statement. Because of the following reasons,

 Valuation is both art and science, and thus the assumptions we take are subjective in nature.
Some people might be more bullish or more bearish on particular stock than others.
 Personal bias hampers decision taken to form model of any stock. This can be due to
personal relationships, personal liking of products/ services. This could alter the valuation
 Valuation does not have any fix standard process. Its different for different types of
companies. For example, a startup valuation process will be very than a established
company. Similarly, an internet company Vs manufacturing company
 It depends on a number of factors and a slight change in the value of any one factor can
produce varying results
 It is also not possible to exactly know what will happen in future and no analyst can ever
claim to be perfect in valuing a company

8. Apart from the agency issues (Bob Hatch’s personal interest), what might be other reasons
for overvaluation of Interstate Bakeries by Hatch-First Boston in 1987.

Ans. Apart from personal interest of Bob Hatch, other reason might be that,
 First Boston did not go thoroughly the financial data of the Interstate Bakeries, if they would
have done then they could have noticed the profit surge was due to lower raw material cost
 The stock market (S&P index) had surged quite sizeable due to which the stock price had
shoot up and also when indication was shown of selling the company, prices went from
$28.875 to $36.25
 The above increase in stock prices, might have given more confidence to Hatch-First Boston
that company has sizeable good will in the market